Don’t forget the debt: there’s more to fiscal prudence than a return to surplus

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Kevin Davis does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

Treasurer Swan’s commitment to bring the government budget into surplus in 2012-13 may be a political imperative, but is not good economics. The focus for prudential fiscal management should instead be on what budget outcome is consistent with an appropriate path for government debt outstanding.

A budget deficit outcome of $10 billion or so would not appear inconsistent with prudence, and effects of fiscal policy changes on economic activity also need to be taken into account.

Just as we do not expect businesses to operate without some debt outstanding, so we should not expect governments to be debt-free. Some part of their expenditures are capital investments benefitting future generations and warrant some degree of funding by borrowing rather than by current taxation (such as deficit financing).

What is an appropriate level of government debt? There is no unique right answer, but lots of wrong answers.

Levels such as those currently found in Europe and the US are clearly not the right answer. Meeting the level of interest payments involved imposes budgetary constraints on other real budget expenditures in order to avoid a vicious debt spiral, and national financial credibility is threatened.

Neither is a zero level of government debt optimal for a country that has substantial public sector assets and capacity to raise income via taxes. And zero debt means an absence of a government securities market – not something appreciated by financial markets.

In thinking about appropriate government debt levels and implications for budget surplus/deficit settings, it is common to focus upon the debt to GDP ratio. Scaling by GDP makes sense since that is indicative of a government’s capacity to raise funds (via taxation) to repay debt principal and interest.

At June 2011, federal government debt/GDP was 13.7%, more than double the low reached in the mid 2000s, but still well below the average of 17.9% for the period 1983- 2000. Keeping that ratio roughly constant would not seem like a bad fiscal objective, and is certainly better than aiming for a massive fiscal shift to a budget surplus at a time when the economic outlook is unsettled.

How does the debt/GDP ratio evolve over time? There are three relevant factors. First, interest owed on existing debt (and included in the budget deficit) adds to the numerator, pushing the ratio up. But second, growth of GDP adds to the denominator, and drags the ratio down.

While the arithmetic and accounting is a bit complex, these two factors arguably cancel out at the moment. Historical government debt costs are in the order of 6% per annum (public debt interest in 2011-12 was projected at $11.6 billion on debt of $191 billion). But rollover of some higher-yield debt at lower current market rates, suggests a figure of 5.5% as a reasonable estimate going forward. Projected nominal GDP growth is also in that order of magnitude - although forecasting is a risky business.

That leaves the third contributing factor, which is the primary budget deficit: the deficit of government expenditure on goods and services, excluding interest payments, over taxation revenue. With the other factors driving the debt/GDP ratio roughly cancelling out, a zero target for this variable would lead to the ratio remaining roughly constant.

For 2011-2012, the planned deficit was approximately $32 billion, and public debt interest projected at $11.6 billion, such that the primary deficit was around $20 billion. Dropping that to zero would leave an overall budget deficit of around $11-12 billion (the interest component) which appears to be consistent with not much change in the government debt/GDP ratio.

While the above estimates are indicative (and parameters and forecasts involved subject to debate), the critical take-home message is not about the numbers per se. Rather, it is that the budget deficit/surplus should not be the sole focus of attention when thinking about prudential government fiscal management.

The implication of budget settings for the evolution of the government debt position is a much better focus of attention when fiscal prudence is being discussed. And at the current time, on that criteria, it is far from obvious that prudent fiscal management involves a massive shift in the budget outcome to overall surplus.